3 things you need to watch out for when investing in emerging markets

Historically, emerging markets have been both the darling and the crux of investors. This is because its emerging markets’ growth potentials have drawn excited investors who are seeking high returns on their investments, while the instability of these markets have also caused them heavy losses.

If you look at our table below, it’s easy to glean that the developed markets like S&P 500, DAX and FTSE 100 have done quite well relative to other markets both in 2016 and so far in 2017. Compared to these markets, emerging markets’ allure and dangers: while there were pockets of extremely good performance like in Russia, Thailand and Brazil in 2016, Russia is the worst performing market so far in 2017, while markets like Singapore that heavily underperformed in 2016 are doing well so far in 2017.

Stock Market Returns 2017 YTD Return 2016 Return
S&P 500 7.1% 11.2%
DAX5.1% 11.6%
FTSE 100 3.4% 17.2%
TOPIX2.3% 0.6%
Nikkei 225 1.5% 3.6%
Straits Times Index 8.4% 1.6%
KOSPI3.2% 5.6%
Shanghai Composite 4.6% -5.8%
Hang Seng 8.1% 3.2%
Stock Exchange of Thailand SET Index 1.6% 22.1%
Jakarta Stock Exchange Composite Index 1.3% 17.0%
MSCI Russia Index -5.2% 51.7%
Vietnam Ho Chi Minh Stock Index 6.7% 15.7%
MSCI Malaysia Index 3.5% -0.3%
Kuala Lumpur Composite Index 3.4% -0.7%
MSCI India Index 8.5% 1.6%
Índice Bovespa (Brazil) 11.2% 42.9%

If you are hunting for undervalued stocks to own in these emerging markets, you should know that you must tread very carefully. The usual metrics and analysis that an average investor does in the developed markets may not always apply in the same way when you are investing in Brazil or Malaysia. Below, we highlight a few major factors to which you should pay extra attention in order to avoid facing heavy losses as well as earn great investment returns.

Corporate governance

One of the biggest dangers of investing in emerging markets is corporate fraud as well as bad managements destroying the value of their companies with shareholder unfriendly policies. Because the auditing infrastructure in these countries is often insufficient, many listed companies have either faked the size of their businesses or stolen cash from their bank accounts. There are also other less serious cases where management teams make irrational decisions in order to maintain control of their firms instead of doing right by their shareholders.

There are several things that you can look out for in order to filter out companies that could possibly fall into one of the aforementioned categories. First, you should first look at the history of the firm and see if they’ve ever returned capital to their shareholders in a meaningful way. Especially when the stock price has been declining, the company’s share buybacks can be a significant vote of confidence in the health of a firm’s business. Not only that, if the firm has been increasing its dividends consistently with its rising profits, it is generally a good sign that the management team is conscious of taking care of its shareholders. The fact that the company can deploy a meaningful amount of money to buy its own stocks or pay a consistently increasing dividend also confirms that the company’s business is real and actually generates some cash profit.

Secondly, you should look up the shareholding structure and see if there’s any “insiders” (i.e. management team, founder, chairman, etc.) that own a significant amount of shares in the company. Then, you should look up how they’ve changed their ownership in the company over time. Usually, you want to avoid investing in companies whose insiders have only sold their shares: it implies that they are trying to cash out while good times last (if it’s not a fraud). Therefore, you should aim to invest in companies whose insiders are always buying more shares whenever their stock prices drop meaningfully. Nobody knows these companies better than the insiders, and if they are willing to use their own cash to buy more stocks, it’s usually a good sign.

Currency volatility

One of the biggest risks of investing in emerging markets is the volatility in currency exchange rates. Even if you were to earn a 20% return on your stock in Thailand, if Thai Baht loses 20% of its value against SGD, you would have barely broken even. In order to avoid this, you could main do two things. First, you can hedge your currencies so that you are only exposed to the change in your stock’s price. For instance, if you are buying a Hong Kong stock, you can short the HKD for every dollar you are investing: if you own S$1,000 of HK stocks, you should be shorting S$1,000 of HKD. The second measure you can employ is to do a lot of research on possible FX movements. This obviously is very difficult to do, and we do not recommend it to a casual investor.

Other singular risks (political, environmental, energy, etc.)

There are other risks you should be aware of. Many emerging markets have a very unstable political scene, and this could cause a detrimental loss to your investment portfolio if you are unlucky. Not only that, many emerging markets are heavily dependent on a specific commodity or energy product, so any disturbance in those markets can cause a massive panic in emerging markets. When you are investing in these regions, it’s good to keep track of all the possible “black swan” events that may seem unlikely but could be extremely damaging.

Conclusion

Emerging markets can be both exciting and dangerous place for stock investors: high reward usually comes with high risks. While the above tips can help you weed out most of the “dangers” in investing in these markets, you should always do a lot of due diligence and buy stocks only when there’s enough margin of safety: ideally, you want to buy things that are so undervalued that you can avoid losing money even when your research was wrong. If you do all of these, you could make decent returns over a long period.

This article first appeared on ValuePenguin.

DJ is the Head of Asia at ValuePenguin, a research and data driven personal finance company based in New York. He previously worked as an equities investment analyst at various hedge funds including Cadian Capital and Tiger Asia, focusing on the global technology, financial and consumer industries. He graduated from Yale University with a degree in Economics.

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